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Wall Street's Eeyore sees good times ahead

Whatever happened to Richard Bernstein, Wall Street's favorite pessimist? He's an optimist now.
/ Source: The Associated Press

Whatever happened to Richard Bernstein, Wall Street's favorite pessimist? He's an optimist now.

The former chief investment strategist at Merrill Lynch built a reputation as a contrarian throughout the 2000s, the era of cheap credit. As home prices soared, Bernstein saw a bubble and told investors to abandon homebuilding stocks. When subprime mortgages started to sour, he warned of the danger to banks. His skepticism earned him the ire of stock boosters. Bernstein was thought of as the guy ready to rain on any parade.

The financial crisis changed all that. With investors now wary of stocks and market pundits looking for daily signs the sky is falling, Bernstein believes the conventional wisdom is wrong, again. The economy is stronger than you realize, he says. And the man who shunned stock markets is out telling people it's a great time to buy small-company stocks.

"The common theme today is that the U.S. stinks," he says. "But the economy is already in better shape than people think."

If you agree with Bernstein, you'll want to follow him into small companies that look cheap compared with their peers, a group investors call "small-cap value." They're the most likely to trounce other investments if the economy recovers its footing, and also the most likely to fail in a downturn. If you think the economy stinks, you'd be in the company of his old friend David Rosenberg, the former chief U.S. economist at Merrill Lynch.

It's only very recently that these two prominent investment analysts parted ways in their views about the economy. During their many years together at Merrill Lynch, both Rosenberg and Bernstein were steadfastly skeptical of the housing and stock booms.

"We were joined at the hip," says Rosenberg, who's now the chief economist at Gluskin Sheff in Toronto. Both left Merrill Lynch soon after Bank of America Corp. took it over in 2009.

Rosenberg, who remains reliably gloomy, says he's ready to turn positive on the economy whenever the time is right. With his friend and former colleague Bernstein now bullish on the U.S. economy, "I'm Wall Street's real perma-bear," he deadpans.

Unlike when he was the chief strategist at Merrill, Bernstein has money to put behind his contrarian views. The Richard Bernstein Multi-Market Equity Strategy Fund launched Oct. 12 with the backing of asset management company Eaton Vance. It's considered a "macro" fund. That means all investment decisions spring from Bernstein's overarching view of the world. Stocks are collected based on how well they fit into the big picture.

The fund's billing says it will target "overlooked areas across the global equity markets." That's no easy task as investors spent the past two years pulling cash out of the U.S. stock market and plowing it into areas long considered dicey, like emerging markets and junk bonds.

At a recent conference, a financial planner asked Bernstein: What's overlooked these days? The answer, he said, is right under your nose: small-company U.S. stocks, specifically the undervalued ones.

Bernstein says investors have shied away from them because their fate is so closely tied to the economic cycle. Most people aren't convinced the economy has regained its footing, which is why small companies have found it harder to get a loan from banks or raise capital from investors.

Bernstein tells people they should learn a lesson from organized crime, which found success by providing cash to those who couldn't get it from banks.

"They lend to where capital is scarce," he says. "As an investor, that's the way you should think. Obviously, when it comes to collecting your money it's a different story."

Bernstein's fund has yet to detail its holdings with regulators, so he can't name the companies he owns. However, you can see how it compares with his benchmark MSCI All Country World Index, which tracks global stock markets.

That index has 14 percent of its holdings in emerging markets, but Bernstein's fund has just 1 percent. Small stocks make up 1 percent of the index, but 26 percent of Bernstein's fund at the end of October.

If Bernstein's view of the economy prevails, academic studies and performance data suggest he's making the right bets. Katie Rushkewicz, a fund analyst at Morningstar, says smaller companies tend to beat other companies over the long term.

Mutual funds that target undervalued small companies have returned an average of 10 percent each year since 1995 and 8.96 percent since 2000, beating all other categories of stock funds, according to Morningstar's data.

Rosenberg, Bernstein's former colleague at Merrill, believes the economy is in for a long slog. During the depth of the financial crisis, he wrote a report arguing that Americans would spend the next few years repairing their personal finances, saving and paring their debts.

The report proved to be a remarkably clear-sighted preview of what was to come. Almost two years later, he still sees plenty of problems. The only reason the unemployment rate isn't higher than the current 9.6 percent, he says, is because many people have given up trying to find a job.

Homeowners in the U.S. haven't recovered from the housing bubble either. In the past, Americans owned a larger stake in their homes than they owed on their mortgages. That relationship reversed in 2007 and remains that way, Rosenberg says. Homeowners now have $10.5 trillion in residential mortgages and only $7 trillion in equity.

Asked what he thought of Bernstein's optimistic turn, Rosenberg says: "I love him like a brother, and if I was starting a fund I'd be saying the same thing."